SDGR - Zai Labs: Biopharma's Alibaba But Better

Summary

• Zai Lab Limited is a relative new entrant to the Chinese pharma space and has multiple approvals and a large clinical pipeline.
• Founder Samantha Du seems willing and capable at driving commercialization partnerships with foreign entities.
• Also, the in-house pipeline is set to produce global therapies in due time, leading to tremendous opportunity.
• Despite these positive indicators, the Zai Lab share price has fallen 70% from highs.

Introduction

Zai Lab Limited ( ZLAB ) is a rapidly growing, fully integrated biopharma (mix of biotech and pharmaceutical) based in Shanghai, with offices across Mainland China, Macau, and Hong Kong, along with new global R&D and business development offices. Relatively new R&D facilities in the Bay Area and Cambridge, Massachusetts, signal the global opportunity that this Chinese biopharma company is attempting to benefit from.

As Zai Labs uses profits from their current commercial partnerships to invest in globalization, I believe there is a high chance that the valuation will improve from current levels thanks to sentiment alone. When adding in the fact that growth is well set for the future thanks to the wide pipeline and new operational partnerships, the opportunity seems exceedingly skewed to great returns for investors.

However, as has been the case across the Chinese investment landscape, economic woes, regulatory scrutiny, geopolitical tension, and generally poor investor sentiment have depressed the company’s share price and valuation. Just look at the return chart of Zai Labs, e-commerce leader Alibaba Group Holding Limited ( BABA ), and the Chinese market as a whole, in the chart below.

Despite the beat-down in price over the past year or so, the actual company progress suggests that the negative performance is merely due to fluctuations in valuation due to sentiment. Therefore, I believe Zai Lab Limited is a perfect contradictory and turnaround play for investors heading into 2023. This article will lay out the key reasons why.

The Chinese Regulatory Risk

One of the first issues surrounding Zai Labs’ valuation is due to the lack of acceptance for Chinese technology, their drug approval process, and economic health. I find that most of these issues, and the corresponding guillotine to valuation over the past two years, are overblown and temporary for Zai Labs. In particular, the fact that the company is looking to become a global entity, rather than only operate in China, is important. To do so, Zai Labs is pursuing three main courses of action:

• In-house drug discovery, whether in China or abroad, and securing both Chinese and FDA approval for these therapies. So far, only Chinese approvals have been secured for a few therapies, but further expansions and data collection are underway.

• Collaborate with either Chinese or foreign drug developers to perform clinical trials and expand the presence of their therapies (i.e. partner with a US manufacturer to commercialize an approved drug on the Chinese mainland).

• Secure working ties and relationships with global entities in order to improve transparency and trust. In 2021, Zai Lab formalized over 9 new deals with companies such as Seagen ( SGEN ), argenx ( ARGX ), Karuna ( KRTX ), Blueprint ( BPMC ), Schrodinger ( SDGR ), Mirati ( MRTX ), MacroGenics ( MGNX ), and more.

For now, Zai Labs will be relegated to research collaborations and partnerships to bring in FDA approved therapies to China. However, I look forward to the point where Zai Lab will earn significant revenues for therapies sold around the world. However, another risk point is the clinical approval climate in China. In particular, can therapies approved in China even become approved by the FDA?

Well, it is safe to say that worries about the accuracy or risk of the Chinese clinical approval process are limited to special circumstances, particularly feedstock production sites. For pharmaceuticals, most issues are not the result of the actual R&D or clinical trials, but that the Chinese population is too homogenous, and the data cannot be safely reflected out to global populations. As reported by Biospace and the Wall St Journa l, the FDA has spoken out about this issue before:

'We have nothing against drugs being developed in China. Our issue is, are those results generalizable to the U.S. population?' [director of the FDA's cancer-drugs division] Pazdur said.

When drugs are tested only or primarily in one country such as China, Pazdur stated that it is 'difficult to assess whether the drug would have the same benefits and safety profile in the U.S. population.' He added that there may be differences between countries in medical care and population that affect how a drug performs.

Now we see why Zai Lab is putting significant effort into their global presence: to gain a clinical population base that can serve global populations. Then, upon FDA approval and success, particularly in regards to facility inspections and adherence to cGMP manufacturing, the door is blown wide open for ZLAB. As discussed by S&P Global :

Gaining FDA approval not only unlocks the door to overseas expansion, it also endorses a company's research and development capability, which is highly sought after among Chinese biotechs that have not yet accrued an international reputation.

'The U.S. approval might be interpreted as an important recognition of a drug's efficacy or safety results, a drugmaker's independent research and development, and global execution capability,' said Cerina Zhang, an analyst at Macquarie Group.

China has long been known for producing generic drugs. However, the increasing number of scientists returning from work and training abroad, combined with an injection of both private equity and government investment, has boosted the country's innovative drug development in recent years. So far in 2021, China has approved 54 innovative drugs — most developed by domestic companies — compared to 36 novel treatments approved by the FDA, according to Pharmcube.

Early-stage, but Qualified

Along with work on internal R&D and commercialization collaborations, Zai Labs also have experience performing CRO (clinical research) work. In fact, the company claims they are able to perform trials, build regulator approved facilities, and gain approval far faster than other Chinese peers. The image below highlights all of these successes, but I believe the most critical piece of information for investors is the fact that research has been increasingly global and is recognized by both China and the FDA.

Much of this work will require strong management, and I believe that Zai Labs is also strong in this aspect as well. Although the company was only founded in 2014, the founder and CEO Dr. Samatha Du has built an executive suite full of globally experienced persons. Her own leadership seems strong, with Forbes reporting :

'Dr. Du pays a lot of attention to the market potential of licensed products,' says China Renaissance analyst Zhao Bing in Shanghai. 'And she really has the China know-how to commercialize them.'

Du has the experience needed to spot promising imports. After graduating in 1994 with a Ph.D. in biochemistry from the University of Cincinnati, she landed a job at Pfizer. In 2001, she became chief scientific officer at Chi-Med, a cancer-drug developer in Hong Kong backed by billionaire Li Ka-shing. During her tenure, Chi-Med developed Fruquintinib, which in 2018 became the first homegrown cancer drug to win regulatory approval in China. In 2011, Du joined Sequoia China to hunt for healthcare investments, then started Zai Lab three years later.

Current Approvals

ZLAB currently holds the rights for multiple approved therapies, however, all are relegated to commercialization in China, Macau, or Hong Kong for the moment. This is due to the fact that these therapies are primarily partnerships with foreign entities to expand FDA approved therapies to China. In fact, most of the pipeline remains restricted to China only for commercialization, although early stage trials are now expanded to global rights. Thankfully, the Chinese healthcare market is growing rapidly and the sales that Zai Lab will be earning will be easily invested for future profits.

Due to the numerous benefits and beneficial company qualities, Wall St remains bullish on Zai Lab. In fact, the current average price target suggests a 134% premium over the current share price. Let’s dive into the financials to see if the quantitative data matches the pros of the qualitative data.

Financial Data

Perhaps the most important aspect of a discovery-stage biopharma company is the amount of losses per quarter. While Zai Lab has a favorable profile of assisting foreign entities in Chinese expansion, significant expenses are being driven towards Zai Lab’s own internal R&D and manufacturing capacity. As such, operating expenses remain far above current revenues, with both increasing over 100% annualized over the past few years. However, we can also see that SG&A expenses are not increasing at the same rate as revenues and this suggests that the company may be able to be profitable in the future as it matures.

To support operational losses, Zai Labs has established a $1 billion pile of cash, primarily through various IPOs, milestone payments, and investments. This has come with a fair share of dilution over the past five years, but that is part of the biotech game. With FCF losses now averaging over $100 million per quarter, the company has approximately two and a half years of operations supported by current cash. Although, revenues are fast increasing over $50 million per quarter and this will help offset future investments and potentially reduce the average quarterly losses. Overall, the balance sheet is quite healthy and supports the investment thesis over the next few years at least.

Valuation

Based on all the factors I have discussed so far, it may seem surprising that Zai Lab has seen over 70% of their market cap wiped out over a year and a half. Now at a 16x price to sales, the company is trading closer to larger biotechs such as BeiGene, Ltd. ( BGNE ) and Seagen, despite the rapid growth in store.

In fact, most early stage biotechs have far higher valuations, especially when as diversified as Zai Labs, and so I feel confident that the low valuation is temporary. However, the truth is that sentiment regarding U.S.–China relations will remain an issue that is agnostic to financial performance, so the investment remains volatile and speculative.

Conclusion

Despite the strong qualitative and quantitative indicators suggesting Zai Lab will outperform significantly from current levels, the amount of volatility over the coming quarters will likely be too much for most investors. As such, I believe that Zai Lab offers a great investment for investors looking for a long-term holding rather than a quick momentum play.

There is no need to time your purchases, despite the news of China opening up, as the momentum remains easily in the hand of the bears. But, I do expect the clouds to part at some time down the line and I believe investors accumulating on a regular basis in late 2022 and early 2023 should see above-market returns for Zai Lab Limited over the coming years.

Thanks for reading. Feel free to share your thoughts below.

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